Why You Should Buy Pre-Election Stock Market Dips

As long as the SPDR S&P 500 ETF Trust (SPY) stays above key support, bulls should buy stocks on October dips

Senior Vice President of Research
Oct 3, 2016 at 8:42 AM
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"There are other macro events on the horizon, including this week's informal Organization of the Petroleum Exporting Countries (OPEC) gathering in Algeria… Just as market watchers did not expect a rate hike, they do not anticipate a production freeze from the cartel..."

"From an options standpoint, SPY options sellers would like to see a pin at the 217 strike, where there is a healthy amount of put and call open interest. The 217 strike is also sandwiched between heavy out-of-the-money call open interest overhead, and heavy put open interest at strikes below."
-- Monday Morning Outlook, September 26, 2016

Last week was chock-full of headlines, ranging from 2016's first presidential debate on Monday night, to major developments that impacted financial and energy stocks, which account for almost 25% of S&P component stocks. Despite the news, on a net basis, there was little directional movement on a Friday-to-Friday closing basis.
One major headline involved the surprise compromise from the Organization of the Petroleum Exporting Countries (OPEC) to implement a production freeze of 32.5 million barrels beginning in November, with further details of the agreement coming that month at a formal meeting in Vienna, Austria. As I mentioned last week, an agreement was not expected and, as such, energy stocks popped on the news, helping support the equity market.  

Moreover, stocks tanked on Thursday when rumors surfaced that hedge funds were moving their business away from Deutsche Bank (DB). Hedge funds had reason to worry, as the Department of Justice was seeking a $14 billion settlement from the bank related to its selling of mortgage securities.  When this settlement number was first announced, DB had about a $20 billion market cap.  But the DB headlines took a sharp positive turn on Friday morning, as rumors emerged that a $5.4 billion settlement was near -- significantly less than the original $14 billion that was being sought.

In fact, Fed Chair Janet Yellen's congressional testimony seemed to take a backseat to the OPEC and Deutsche Bank news. With the SPDR S&P 500 ETF Trust (SPY - 216.30) closing the prior week at $215.99, stocks closed barely higher on the week -- in between the 216 and 217 strikes that were noted as having significance on Twitter and in last week's commentary.  

Further, the prior week's close was just a penny shy of the 216 strike price, which was the point of maximum pain for SPY 9/30 quarterly expiration option buyers, as I observed on Twitter last week. In other words, a close at the 216 strike would result in the maximum number of call and put options in the SPY 9/30 series expiring worthless -- a big payoff for SPY premium sellers and a disappointment for most speculative option buyers.

spy daily july-september trading range

"… we come into the week smack in the middle of the range explored since the SPY broke out above its June closing high at $212.37. From a chart point of view, a case can be made that the SPY remains directionless, with U.S. elections only weeks away and visible boundaries above and below current levels."

"…the Schaeffer's open interest put/call ratio (SOIR) on the IWM is above 4.0 -- an extreme high... the short-term (two-week) returns are impressive only if you are looking to play a move to the downside. However, the longer-term implications -- looking out one month and beyond -- are much more favorable, and support the bullish technical pattern we observed on small caps in early August."
-- Monday Morning Outlook, September 26, 2016

Note that the iShares Russell 2000 ETF (IWM - 124.21) is still trading around resistance in the $123.88 region, which is significant because this level represents its 10% year-to-date gain. As I noted on Twitter last week, since reaching this level in August, the IWM has displayed choppy price action -- which is likely a sign that some profit taking has taken place. Last week, it finished slightly lower, consistent with the short-term weakness that tends to occur when its Schaeffer's put/call open interest ratio (SOIR) hits an extreme reading above 4.0, as it did recently. 

However, the longer-term implications of a reading above 4.0 have been bullish, as detailed in last week's commentary.  This bullish longer-term sentiment indicator supports the bullish "inverse head and shoulders" pattern on the IWM chart, which was also discussed in last week's commentary.

iwm daily april-september

"Investors retreated from U.S.-based funds as stocks and bonds slid, pulling the most cash in the latest week since the British vote to quit the European Union, Investment Company Institute data showed on Wednesday."
    -- Reuters, September 21, 2016

"...Wall Street strategists, whose trepidation about everything from election politics to interest rates and valuations has left them in an unusually bearish mood before this year's holidays. Among 19 surveyed by Bloomberg, the average estimate calls for the S&P 500 Index to end 2016 at 2,171…of course there is the U.S. presidential election. Volatility will likely increase in the weeks leading up to the Nov. 8 vote, according to Lakos-Bujas. Indeed, equity volatility in the November of presidential election years has historically been 22 percent above the average for all months, according to data compiled by Bloomberg."
    -- Bloomberg, September 30, 2016

This week brings a new quarter, and with a new quarter, bulls hope for a breakout from the third-quarter consolidation.  During this consolidation, doubts about a rally to end the year have grown, as depicted in the excerpt from a Bloomberg article this past Friday, entitled, "Wall Street Says Holiday Stock Rally Not in Cards This Year."  

Mutual fund investors, per the Reuters excerpt above, seem to be echoing Wall Street's low expectations for a fourth-quarter rally.  A bull might conclude that there's ample money on the sidelines to fuel a fourth-quarter rally. 

Historically, seasonality and the equity price action support the bull case.  For example, Schaeffer's Senior Quantitative Analyst Rocky White looked at historical fourth-quarter S&P 500 Index (SPX - 2,168.27) returns when the index was up year-to-date by single digits after the third quarter -- which is the case now -- in his Wednesday "Indicator of the Week" column. Per the table below, the SPX has registered its best fourth-quarter returns under these conditions. 

spx 4q returns

However, his research also indicated that in election years, while the fourth quarter tends to be positive almost 75% of the time, its average and median returns are the weakest when compared to the first, second and third year of presidential cycles.

spx 4q returns election cycle

Finally, Rocky went on to produce a fascinating graph that depicts the typical path of the market during the fourth quarter of an election year.  As you can see on the graph below, the SPX tends to decline in October of an election year, consistent with the theory that short-term uncertainty may weigh on investors in the weeks ahead of the election. That said, a volatility pop in October would likely reduce the huge number of large speculators' short positions on CBOE Volatility Index (VIX - 13.29) futures that has been persistent for weeks.  

spx 4q returns graph

As such, view any stock market declines associated with election uncertainty as buying opportunities, as long as SPY is above support in the $212 area. While fourth-quarter returns during election years have historically been weak relative to the fourth quarter of other years, buying on an October dip (or October "double-dip") has proven to be rewarding, as October weakness generally accounts for the historically subdued fourth-quarter election year returns.

Continue reading:

Indicator of the Week: Will the Election Hurt Fourth-Quarter Returns? 

The Week Ahead: Jobs, Fed Front and Center

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